Costs Spiral for LNG Projects - Dan Amoss

by Dan Amoss

Russia, Iran, and Qatar control the largest natural gas resources in the world — enough to dominate the future business of shipping liquefied natural gas (LNG) to consumers around the world. But of the three, Russia and Iran don't even show up as LNG exporters in the trade statistics. According to the latest BP Statistical Review, the three biggest exporters of LNG are Qatar, Indonesia, and Malaysia.

Russia and Iran have legacies of Marxist policies and generally have trouble getting along with their neighbors, so they haven't exactly been fostering the type of environments that attract international investment. And investment is what they both desperately need.

Iran is a basket case, and as long as the clinically insane are running the show, the country is unlikely to attract the investments in technology and capital assets it needs to transform its natural gas reserves into a tradable commodity. But Russia is apparently open to foreign investment, as long as that foreign ownership is limited to small, non-controlling stakes.

Despite all the headlines of Russia confiscating big projects started by international oil companies, the country doesn't want them out entirely. On July 9, BBC News reported that state-controlled gas giant Gazprom, after discovering how difficult and costly it would be, is sheepishly reapproaching the companies it had kicked out of the Shtokman gas project:

"Russian gas monopoly Gazprom has said it is close to pairing with foreign firms to start developing the world's largest offshore gas field.

"The comments made by one of the firm's top executives, Alexander Medvedev, mark a dramatic U-turn from its tough stance last year.

"Last October, Gazprom said it alone would exploit the untapped Shtokman gas reserves in the Barents Sea.

"Signing a deal would be a major boost for any of the overseas firms involved.

"Norway's Statoil and Hydro, ConocoPhillips and Chevron in the U.S., and France's Total had all been shortlisted as potential members of a consortium to start pumping gas from the strategically crucial Shtokman field on the ice-free Kola Peninsula.

"But Gazprom dealt them all a huge blow last October when its chief executive Alexey Miller said Gazprom would take control of 100% of the resources.

"The 1,400-square-kilometer field has the potential to become the world's largest offshore gas field with 3.2 trillion cubic meters of gas contained in reservoirs 2 kilometers below the seabed -- itself at a depth of 350 meters.

"The cost of the operation has been estimated at between $20-30 billion, which Gazprom would have to foot if it decided to go it alone.

"Mr. Medvedev [said] Gazprom was in talks with foreign companies to allow them to 'share in the economic benefits of the project, share the management, and take on a share of the industrial, commercial, and financial risks.'

"This would be through overseas companies taking a stake in the company created to operate Shtokman, while Gazprom will retain control of the license to the field."

To place it into context, Shtokman's estimated reserves of 3.2 trillion cubic meters translate to about 113 trillion cubic feet, or the amount of gas the entire U.S. economy consumed over the past five years.

This is a smart move on Gazprom's part because the estimated development cost of $20-30 billion is probably a fraction of what it will ultimately turn out to be. Many projects that resemble Shtokman in scope and complexity are struggling with major cost overruns.

This plays right into the hands of companies like Chicago Bridge & Iron, Foster Wheeler, and the infamous Iraq contractor Kellogg Brown and Root (KBR — recently spun out of Halliburton). The stocks of these companies are expensive for good reason: They're all big players in the engineering and construction of LNG liquefaction terminals, so their businesses will benefit as this market grows and continues to experience cost inflation.

Despite the fact that it's proceeding at a slow and expensive pace, the continued growth in liquefaction capacity raises the possibility of the LNG market eventually looking like the oil market does today — with a few players dictating the terms under which they'll export gas. Rumors of a planned OPEC-like natural gas cartel have even popped up in recent months.

But they are way ahead of their time.

In order for a gas cartel to develop, its members must control huge shares of low-cost global gas production and cooperate to suppress supply. Not to mention the fact that the majority of gas consumption would have to be shipped via LNG — rather than pipeline — so it can be sold to the highest bidder (like the oil industry). The LNG market may not develop to this degree for another 20 years, if ever.

Petroleum Review Sees Cost Pressure in LNG "Megaprojects"

Chris Skrebowski, editor of Petroleum Review, follows the progress of major LNG projects as closely as he follows major oil projects. Drawing from his observations of the Energy Institute's IP Week conference, Skrebowski explains that the marginal cost of LNG is increasing rapidly:

"Considerable uncertainty remains for projects due to startup in 2010 and later. In the course of a presentation during IP Week, Andy Flower, an LNG consultant, produced a listing of projects that had been expected to get final investment decisions (FIDs) in 2006. This is because no FIDS have been signed off in the last 18 months."

Apparently, a lot of engineering and design work is under way, but companies remain hesitant to fully commit capital to liquefaction projects. Rapid increases in Greenfield construction costs have "reversed all unit costs reductions in the last 20 years. This means new liquefaction trains will have markedly higher unit costs than recently built ones."

Since Asian and European markets will experience growing demand for reliable supplies of seaborne LNG, the regasification terminals slated for construction on the Gulf Coast (primarily by publicly traded Cheniere Energy) may face the prospect of having to pay unprofitably high prices to import LNG to the U.S. "The problem is that the lack of new [liquefaction] projects is now certain to produce a supply shortfall around 2012 [emphasis added]. The time from [final investment decision] to first gas is normally around four years," writes Skrebowski.

U.S. Gas Supply Will Rely More Upon LNG and Drilling Activity

What does a potential shortage of LNG by 2012 mean for U.S. gas consumers? First and foremost, it means that the U.S. must keep drilling intensely on its own land to maintain the domestic gas production its home heating, electricity, and petrochemical industries rely heavily upon.

The big white space in this chart is the portion of U.S. gas demand that's fulfilled by homegrown drilling. About 80% of gas demand is produced locally, while 17-20% is piped in from Canada (shown in blue) and 3-5% is imported as LNG (shown in red) — mostly from Trinidad and Tobago:

Zooming in to a smaller scale shows the trends since January 2001. Pipeline imports from Canada decline each year during the "spring breakup." When the ground thaws each spring in Canada, it becomes too soft to move around heavy drilling equipment, so production and exports to the U.S. temporarily decline:

But beyond the seasonal swings in gas imports from Canada, an important trend is emerging. I make note of it in the chart above. A growing share of Canadian gas production will be consumed by tar sands projects as production is projected to grow by a few million barrels per day over the next decade; this mined substance consumes a great deal of natural gas as it's upgraded into useable fuel.

Furthermore, in its quest to cut down on carbon emissions, the Canadian government is pushing for the replacement of its coal-fired power plants with gas-fired plants. So what remains of Canadian gas resources may eventually be piped to domestic power plants, rather than exported to the U.S.

A final blow to U.S. pipeline imports: Gas supplies will continue to be limited as long as the Canadian rig count remains near the bottom of its five-year range. Last Halloween's decision by the Canadian government to phase out the tax-favored status of energy trusts not only upset scores of income investors; it also dramatically curtailed drilling projects that are vital to sustain oil and gas production — and exports to the U.S.

So despite the fact that LNG imports have grown to satisfy about 3-5% of U.S. demand, this is no reason to expect gas prices to collapse. In fact, this 3-5% figure will have to double and triple in the coming years to compensate for lower Canadian imports.

Lastly, a look at domestic gas production (the maroon section of this chart) shows a flat trend since 2001. This has occurred even as the rig count has soared. So the U.S. will need a healthy, growing domestic drilling rig fleet to avoid shortages in the future:

Rising Drilling Intensity Reveals Need for Rig Fleet Overhaul

As many industry and government sources point out, the U.S. sits on plenty of untapped natural gas resources — especially "unconventional" gas. This is gas that's "nonassociated," meaning it's not a byproduct of oil production, and it requires more significant investment in fracturing and pressure-pumping services to start and maintain production. On the bright side, the best operators in unconventional plays experience drilling success rates north of 95%; so it's more of a manufacturing operation than it is "wildcatting."

But the key aspect to remember about growing unconventional gas drilling activity is that it will require a large rig count and a growing oil field service industry.

In a Feb. 27 Strategic Investment weekly update entitled "Opportunity in Unconventional Natural Gas," I wrote:

"I constructed the following two charts to illustrate this rising trend in drilling intensity. This information is publicly available on the Web sites of the Energy Information Administration (EIA) and oil field equipment and service company Baker Hughes.

"The blue line is the Baker Hughes Natural Gas Rig count in the 'lower 48' United States, including offshore basins. By 'gas' rigs, Baker Hughes refers to rigs drilling for natural gas in U.S. territory. Out of the total U.S. rig count, gas rigs now comprise about 84% of active rigs, with oil rigs comprising the other 16%:

"As you can see, 10 years of monthly data refute the oft-repeated line, 'Newly built drilling rigs coming online will lead to a glut of natural gas and cause prices to crash.' This is cited as a reason why so many drilling and E&P stocks remain cheap.

"The second chart combines the two data sets from the first chart — it's monthly U.S. gas production divided by the monthly rig count. A simple regression line shows a clear trend running from 3 bcf per month per rig 10 years ago to 1 bcf per month per rig in 2006:

"What conclusions can we draw from this chart? Well, it lends heavy support to the view that drilling demand will more than absorb any increase in the rig population. Most E&P companies are earning huge returns on invested capital at current gas prices. So they will bid aggressively to put newly built rigs to work on their drilling projects.

"Another conclusion? Just maintaining current natural gas production will require a steady uptrend in rig activity (the blue line in the first chart). This can be achieved by building more rigs and refurbishing the huge population of rusted-out rigs left over from the early 1980s drilling boom…

"So disregard headlines about the impending wave of new rigs destroying the drillers' profit margins. Many will be put to work on unconventional gas projects where break-even gas prices are in the $2-4 per mcf range. Unconventional gas production is very drilling intensive because operators are seeing 60-70% production decline rates after the first year of production from a new well."

So what investment conclusions can we draw from the trends transforming the natural gas industry?

First, growth in LNG trade is important to satisfy demand. Most of the world's largest gas resources are located far away from major population centers, as you can see by looking at the map of the Shtokman field. There's no shortage of LNG shipping or regasification capacity at the moment, but there's a growing shortage of liquefaction capacity. Once the billions are ultimately spent to build out this capacity, U.S. importers may very well have to outbid Asian and European customers for LNG. This makes U.S. gas drilling activity all the more important.

Second, since the existing land drilling industry was largely constructed during the early 1980s oil boom, most of its equipment is nearing the end of its useful life. Lots of new rigs are being constructed, but they'll be necessary to replace those that are retiring. This trend is long lasting and will favor forward-looking rig operators and equipment companies.

Despite its week-to-week ups and downs, there's a sustainable boom under way in manufacturing, refurbishing, and operating the equipment necessary to meet the demanding drilling environment of the 21st century.

Good investing,
Dan Amoss, CFA

For Whiskey and Gunpowder

Dan Amoss is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland - investment advisors tor one of America's top small-cap value mutual funds over the past 15 years.

Summer Sale - Puru Saxena

by Puru Saxena

We are witnessing a generational bull-market in all types of natural resources (energy, food and metals). This boom in commodities is largely due to supply and demand imbalances plus the ongoing monetary inflation which is adding fuel to the fire.

Today, the various central banks continue to pump money and credit into the system and combined with the rising per-capita consumption levels in Asia and Latin America, you can begin to understand why the prices of commodities are at record-highs.

For sure, this sector has already risen considerably in this bull-market, however I suspect that the uptrend will continue for several more years. Firstly, back in 2001, natural resources were the cheapest they had ever been in the history of capitalism, so this advance has commenced from a very depressed level. Secondly, when adjusted for inflation (even via the bogus official CPI data which understates the inflation menace), commodities remain extremely cheap (Figure 1).

Figure 1: Is this a bubble?

Source: www.thechartstore.com

These days, some analysts are claiming that this bull-market in commodities is solely due to monetary inflation and that supply and demand imbalances have no influence whatsoever. I tend to disagree with their assessment because constant monetary inflation has been our reality since the early 1970's when gold was removed from the monetary system YET the prices of commodities (energy, food and metals) declined significantly between 1980 and 2001. So, it is clear that the debasement of currencies alone is not responsible for the ongoing surge in the prices of commodities.

In order to have a lasting bull-market in any sector, supply and demand must be out of whack. In the case of natural resources today, demand is rising ferociously in China and India whilst supply is struggling. Consider the energy market as an example: At the beginning of this decade, China and India combined used to consume roughly 8% of the world's oil and today they consume over 11%. Now, to illustrate my point that supply and demand are important factors, I would add that this rising demand (regardless of monetary inflation) would not have translated into a higher oil price IF there was an endless supply of oil. In the current scenario however, the oil price is rising because supplies are extremely tight when compared to demand. In fact, I would argue that humanity is staring "Peak Oil" in its face.

Today the average Chinese consumes less that 2 barrels of oil per year and the average Indian consumes less than a barrel of oil per year whereas the average American consumes 25 barrels per year. After reviewing this data, you don't have to be a rocket-scientist to figure out that demand for energy in Asia can only rise in the future. And unless we can find a way to increase supply, the price of oil will continue to appreciate.

If you have invested in commodities, you will be thrilled to learn that apart from energy, the inventory levels of other resources such as base-metals or food are also extremely depleted. And these stock-piles are low due to the sudden and unexpected surge in demand brought about by the rapid industrialisation and urbanisation of China, India and parts of Latin America. A growing percentage of the three billion people in the "emerging" economies are now putting immense pressure on the planet's resources as consumers and the scramble to find more commodities is on. Exploration activity, whether for metals or energy, is at multi-year highs and I suspect that billions of dollars will be spent in the years ahead as nations desperately look for additional resources to feed demand.

It is interesting to note that after the brutal correction in commodities last year, energy, food and base-metals have recovered, however the precious metals have failed to rally. Moreover, if you compare the performance of the various commodities over the past 5 years, you will realise that industrial commodities (base metals and energy) have outperformed the precious metals by a wide margin. This was expected as the economic activity has been very strong recently and gold is a counter-cyclical asset. No doubt, it has been frustrating for investors to watch their gold holdings drift lower for a year. Despite the recent underperformance, I continue to believe that gold is also in a gigantic bull-market which has a long way to run.

You must understand that in the case of base-metals (copper, lead, zinc, nickel and tin), changes in industrial demand and physical supply cause prices to rise or fall. However, when it comes to gold, investment demand alone is the single most important factor that can make or break a bull-market. And the investment demand for gold is directly linked to the public's inflation expectations.

If the masses are worried about future inflation, they tend to convert their cash to gold as a store of value. On the other hand, when the public is calm about inflation, the reverse takes place.

Banks are in the business of lending paper currencies so it is absolutely vital for their survival that the public's confidence in the monetary system remains high and that inflation expectations remain under control. Every central banker knows that if the public really understood the inflation problem, the monetary system would come under strain. So far, the central banks have done a fabulous job of managing the public's inflation expectations. However, I am of the opinion that this is about to change. As soon as the public realises that inflation is much higher than the official CPI data, we could see a stampede towards gold.

Recently, precious metals have drifted lower which is typical at this time of the year. In fact, the wonderful summer sale in on! Remember, corrections during a bull-market are opportunities rather than a problem. Once this consolidation is complete this summer, I expect precious metals to soar towards the end of this year.

In summary, I believe that every investor should take advantage of this correction in metals and allocate a meaningful portion of their net-worth to the resources sector. Rather than buying the physical commodities through index-tracker funds (due to the negative impact of contango), I suggest investors allocate their hard-earned capital to resource-producing companies which in this raging bull-market are still trading at bear-market valuations!

Puru Saxena
www.purusaxena.com

Puru Saxena is the founder of Puru Saxena Limited. Vastly experienced and respected in his field, he is a registered investment adviser with the SFC. He conducts in-depth economic research and formulates our firm's investment strategy.

Puru Saxena has a decade’s experience in the finance industry, specifically relating to investment advice and asset management.

He is a regular guest on various media such as CNN, BBC, Bloomberg TV, CNBC, RTHK, NDTV and TVB Pearl.

“Tin Men” - Fred Sheehan

by Fred Sheehan

Some may remember the movie Tin Men. Set in Baltimore during the 1960s, the main characters, Danny DeVito and Richard Dreyfuss, make a living selling aluminum siding for houses. They are part of a quickmoney operation that leaves customers possibly defrauded and certainly disillusioned. The main plot pits the two against each other in a brawl that eventually destroys DeVito’s marriage. The camera periodically cuts to a courtroom where hearings are held of the shenanigans used to entice customers. DeVito and Dreyfuss are oblivious to the proceedings even though the dubious operation is front-page news. Their battle for one-upmanship, DeVito’s wife, and aluminum-siding sales completely ignores the noose that eventually falls on them, after testimony has condemned them. Whatever crimes (if any) they committed are incidental in political circles, compared to the image contrived of the bureaucrats doing their all to protect the Little Man. One could deduce that devious practices were old hat by the time the authorities decided to act, possibly having collected their own booty before feigning disgust and doling out retribution.

There is little that is new in the current private-equity, hedge-fund, prime-broker, rating-agency, derivative mixture. The question seems to be how the borrowing and leveraging will end. If past is prologue, it will be the politicians who will shut the door. This will be (at least, it always has been) after the tide has turned. (The nature of legislation is reactive.) The current boom is coagulating into the same, dark mixture that drowned the market twice before — in the late 1960s and the late 1980s. The timeline of the earlier periods is repeating itself today: the limited attraction of a new bull market, the massive attraction of an aging bull market, the publicity drawn to victors in a moribund bull market, the overinvestment and overleveraging of funds that lead to a bear market, criminality, and bankruptcy. It is the latter two developments so essential to political involvement: these are tangible (and inevitable) developments. Poor coverage ratios and the structure of payment-in-kind bonds will not make the Congressional docket.

On December 31, 1949, the Dow Jones Industrial Average traded at a price-to-earnings ratio of 7.6:1, with a dividend yield of 7.1%. The yield on the AAA-rated long-bond was 2.7%. The most heavily shorted stocks were automobile manufacturers. The stock market was of limited attraction. It peaked in 1966, swooned, rose, unravelled in 1969, recovered in the early 1970s, then collapsed in 1973 and 1974. The smart money stood aside as the young and restless came to dominate activity. In 1967, Richard Jenrette, co-founder of Donaldson, Lufkin & Jenrette, defined the “great garbage market”, in which old stalwarts like GM and GE were ignored. The public was drawn to United Convalescent Homes and Minnie Pearl’s Chicken System, Inc. New hedge funds opened nearly every day. By 1969, trading volume on the New York Stock Exchange of over 20 million shares a day forced the market to close on certain afternoons.

Conglomerates were the fashionable contraptions composed of unrelated businesses that were better operated under one roof. At least, that was the current wisdom. When they burst into prominence, the public was caught by such surprise, the New York Times was at a loss for words: its society pages would clumsily classify the victors as “conglomerateurs”. Until this need to classify arose, a conglomerate was a rock. These rocks were diamonds, in the speculating public’s view.

Of most importance, as in all financial structures, were the foundations. The foundations grew less stable as they carried more weight. Rising trading volume and the insatiable appetite of hedge funds were a worry, though the bulls thought just the opposite. In 1968, 4,500 mergers were consummated (far more than in any previous year), and 26 of the largest 500 companies were absorbed into conglomerates.

What follows is a case study of an illusion. In a populist age, accumulation of money and companies makes for a fragile empire. Those clever enough to leverage their capital — financial and intellectual — may look upon their fiefdom as a fortress. In the end, they have no more power than the political establishment permits. The establishment is willing to concede much (political and financial interests are often aligned), but those who fly the highest risk the fate of Icarus.

The case of Saul Steinberg v. The Establishment fits the chronological pattern, financially and sociologically, that we see today. At the age of 21, Steinberg started a computer leasing business. It took him three months to lease his first computer. “Ideal Leasing” was incorporated in 1962. In 1964, with earnings of US$255,000 and revenues of US$1.8 million, Steinberg took his re-named “Leasco” public. By 1966, profits had jumped to US$2 million. Leasco stock soared. Steinberg used the stock to buy a flock of companies. He started acquiring shares of Reliance Insurance Company, an established, Philadelphia propertyand- casualty insurance company. With an ever-rising stock price, he took control over the next 11 months. Now, 80% of Leasco’s revenues were from insurance and 20% from leases.

This was only possible because the public had grown stark, raving mad over Leasco stock: the establishment’s back was against the wall. Leasco appreciated 5,410% over the five years (1964 through 1968). For simple comparisons to later periods, this may be regarded as money loaned with very little chance of cash repayment (in the form of security appreciation, profits, coupon payments, dividend payments).

Steinberg, now 29 years old, set his sights on a large bank — “a New-York, money-center bank with international connections”. He threw darts and Chemical Bank was the target, the sixth-largest commercial bank in the United States.

The leader of Chemical, William Renchard, Princeton graduate, member of the right clubs, director of a half-dozen major corporations, trustee of several hospitals and civic organisations, was not pleased. Nor was the board of directors, which included the chairmen of AT&T and of du Pont, the president of IBM, a member of the executive committee of Texaco, and a former president of the New York Stock Exchange.

Steinberg prepared a tender offer, then called Renchard. Renchard suggested they meet for lunch. He sent his car for Steinberg; they met at Chemical Bank’s executive dining room. Of this duel, John Brooks wrote: “there was a sense of backs to the wall, of barbarians at the gate …”. The phrase, attributed to the late 1980s, was already in play.

To thwart the barbarian, Renchard engaged the law firm of Cravath, Swaine & Moore. Cravath drafted legislation, then sent it to both Albany and Washington. The new laws would specifically prevent a nonblank taking over a bank. Governor Rockefeller (whose brother David ran the Chase Bank) urged the New York Legislature to adopt such a bill. A similar bill was sent to Senator John J. Sparkman of the Senate Banking and Currency Committee. Renchard called William McChesney Martin, chairman of the Federal Reserve, known as the “Boy Wonder” when he was chairman of the New York Stock Exchange. Renchard apprised Martin of the situation. Leasco stock fell to US$115 — it had been US$140 before the bid was announced. The stock started to fall the day the tender offer was announced — quite unexpectedly, given speculators’ fever for more and bigger conglomerates. Did the Establishment manipulate the stock market? The question was asked by many.

Steinberg next received a letter from the Justice Department. The letter did not suggest that such a transaction would violate anti-trust laws, but that, “questions under these laws are raised thereby, particularly under Section 7 of the Clayton Act”. (The reader may look it up; no doubt, Steinberg needed outside counsel, too.) Steinberg stewed over the situation at a hotel in Dorado Beach (owned by Laurence Rockefeller) before going to Washington where he met with several members of the Senate Banking and Currency Committee and with members of the Federal Reserve Board. Steinberg found his timing was poor: “The nation’s legislators were in a grimly anti-conglomerate, anti-takeover mood.”

Steinberg — brash and irrepressible as he was — lost his nerve when he met with Senator Sparkman. As Steinberg relates, Sparkman said: “By the way, have you seen the bill I’m going to introduce against bank takeovers? (Calling to his secretary) Miss —, where’s the bill the lawyer from Chemical Bank sent in? I want to show it to Mr. Steinberg.”

Concurrently, the conglomerate craze was ending in caricature. The hostile takeover of Hartford Fire Insurance Company by International Telephone and Telegraph (ITT) was notorious for several reasons — one being Lazard Freres’ advisory fee of well over US$1 million.

Northwest Industries (clothing, pesticides, steel) attempted to buy out B.F. Goodrich. Goodrich volleyed with the standard retaliation tactics — it changed its accounting method, it went on a buyout spree of its own — then it, too, took the line of defence that no amount of financial heft can defeat — it turned to the politicians. The Ohio Attorney General issued an injunction against the merger; the Justice Department brought an antitrust suit to block it.

By analogy, DeVito and Dreyfuss are fighting each other and not reading the headlines. How might this end? On the simplest level, the math stopped working. Smoke-and-mirrors cannot hide an investment unable to pay its bills. When the foundations buckled, a few — and then the many — asked themselves whether the very idea of conglomerates made sense. From a non-mathematical perspective, the ambitions grew too large, the conglomerateurs too vulgar, the hoi polloi got stiffed, and the politicians decided to act. Time magazine spoke for the many. The March 7, 1969 cover asked: “Takeovers in High Gear: Threat or Boon to U.S. Business?” (Pictures of “LTV’s Ling”, “Gulf & Western’s Bluhdorn”, and “Textron’s Miller” adorned the cover: You know Time’s answer.) Late in the same year, the cover asked: “Will There Be a Recession?” In June 1970, answer to the previous question in hand, Time queried: “Is this Slump Necessary?”

Without the volume and intensity pursuing conglomerates, the stock market deflated. Once “liquidity” reversed (to employ the current word that defines markets that will never fall), it was over. Between January 1969 and October 1970 (roughly the period of the Time triptych), the 28 largest hedge funds lost 70% of their assets. Between November 1969 and November 1970, about 100 brokers and financial firms disappeared. They either became insolvent or were absorbed. (New laws followed to protect the Little Man; the legislators were a bit late.) The Dow only fell 36% between December 1968 (from 985) to May 1970 (to 631), but, as in 2000, the fever ran elsewhere. Dun’s Review constructed indices of the ten leading conglomerates, the ten leading computer companies, and the ten leading technology companies. During that period, these indices fell 86%, 80%, and 77%, respectively.

The garbage market expanded and Wall Street polluted the tank with risky (or worthless) securities. John Brooks told the story of a rising star at a Wall Street firm who fell on the losing end of several court judgments after passing bad cheques. The firm continued to promote him. As the stars grew more powerful, they flaunted it; as egos grew, they needed to do the biggest deal. In the wake of Saul Steinberg’s fall, the 29-year-old reflected, “I always knew there was an establishment — I just always thought that I was a part of it.”

If he had been watching the front covers of Time, Steinberg would have known he was too late.

The 1980s differed as a matter of degree, and probably of criminality, but not of substance. The story is well known. What started as a good idea ended in buffoonery. Michael Milken’s group at the investment–banking house of Drexel Burnham educated the world, then dominated it, in the fertile laboratory of junk bonds. The gluttonous, self-enriching LBO overdose in the second half of the 1980s was different than the refinancing of American corporations of the first half.

The first takeover of a public company by a private-equity firm was in 1979, when Kohlberg, Kravis, Roberts & Co. (KKR) bought machine-tool maker Houdaille for US$355 million. This was also the first LBO. It took over a year to find financing, as well it might. The idea of buying a company by loading its balance sheet with debt was new.

It was the meeting of junk bonds and the private-equity firm that created the LBO boom. The early financings were responsibly packaged to permit the companies so structured to cover their debt payments out of projected earnings. In 1980, only 10% of junk bond offerings were for purposes of acquisition; by 1984, this proportion had leapt to 45%. By 1983, future profits (before depreciation and taxes) were projected to be 20% less than annual debt payments. Companies are often forced to make expedient decisions under such pressure. Since workers are the largest expense at most companies, they go.

Saul Steinberg made his own contribution to the English language when he, in effect, blackmailed Disney into paying him US$60 million to call off a takeover bid in 1984. Thus, the very-eighties term “greenmail” came into being. The politicians were growing restless. Legislation mimicking the Chemical-Bank, protection program was drafted. Delaware became the most controversial state in the union with its deep, statutory moat that separated company management from demanding shareholders. An antitakeover measure proposed by Congressman Dan Rostenkowski contributed, to some unknown degree, to the stock market crash of 1987.

After the crash, the stock market recovered, but easy liquidity did not. The deals grew larger, though, with ever more ingenious bonds to finance these monuments to braggadocio. The early Milken bonds included equity participation by the bondholders. From there, the road was trod to zero-coupon bonds and, finally, to payment-in-kind bonds when the company paid nothing at all. It simply issued additional bonds at the imaginary coupon payment date: thus, the “payment-in-kind”. These were generally worthless. At about this time, Michael Milken appeared on the front cover of BusinessWeek. The cover story quoted a Harvard Business School professor who compared Milken to J.P. Morgan.

In 1988, “entrepreneur” (as he was now known) Saul Steinberg paid US$2 million for his daughter’s wedding at the Metropolitan Museum’s Temple of Dendur. This was not a bad thing since it preceded the “tipping point” (to borrow the title of Malcolm Gladwell’s book). But the mood was changing. The catch-phrases — “yuppies”, “the decade of greed”, “Reaganomics” — were repeated endlessly. They offered little in explanation but provided a leitmotif as the public grew disenchanted.

In early 1989, Kohlberg, Kravis paid US$30.9 billion for RJR. This was a very big number. It is difficult for an outsider to assess the efficiencies of such combinations, but they cause anxiety and disorientation. Sneaker jobs were going to Asia. This jumble of numbers and worries is often what we live by. The smorgasbord did not appeal to the tastes of the public or the politicians.

The temper in Washington, already agitated by the growing control of “financial buyers”, grew hostile as the RJR deal gathered greater attention. (The term “financial buyer” was used to differentiate these deals from “corporate buyers” or “strategic buyers.” Corporations were priced out of the merger business.)

Kohlberg, Kravis, and Roberts gathered 400 dealmakers and lawyers at the Pierre Hotel to celebrate. The guests were congratulated for making over US$1 billion in fees. This did not include the junk bond sales and bank loans. Given the times, the dinner received publicity and it was seen as being in poor taste. Michael Milken’s party for Drexel Burnham clients has gone down in history as the “Predator’s Ball”.

Even as the borrowing bubble was peaking, it had already started to deflate. (The analogy in 2007 might be the cracks in the CDO market as private equity continues on its merry way.) In September 1988, Campeau Corporation disclosed a severe cash crunch. Junk bond prices plunged. On December 7, a Drexel Burnham trader turned government witness against the firm. By the end of the month, Drexel Burnham agreed to settle insider trader investigations and paid US$650 in fines. Clients fled the firm. Early in 1989, Michael Milken was indicted on 98 counts of fraud and racketeering.

The junk bond market was stunned, maybe not so much by the problems at Drexel Burnham, but because demand for junk bonds withered. Junk bond issues rose from US$2 billion in 1980 to over US$200 billion in 1988. There was little thought given to market “liquidity”, since buyers could always be found who wanted more. But this was not to be so. On October 13, 1989 a proposed US$6.79 billion management–union buyout of UAL Corporation collapsed. This caused the stock market “crashette”. (The stock market was priced for junk bond-financed buyouts above the value of companies.) Takeover-stock specialists lost US$1 billion on paper. Eric Gleacher, Morgan Stanley head of mergers and acquisitions, was quoted by the Wall Street Journal: “There was a tremendous backlash caused by the RJR deal. It was the biggest blowup we’ve had … in this cycle” of the merger business. In December, KKR placed one of its companies into Chapter 11 proceedings — Hillsborough Holdings, the first ever bankruptcy filing by a KKR company. The mystique of LBOs was collapsing — lost jobs and bankruptcy were not in the propaganda filing of the “takeover artists”.

The changing times were evident when Saul Steinberg spent US$1 million at a Southampton summer party in 1989. This was half the cost of the wedding but caused an uproar. Party guests told an inquiring press of their outrage. Other guests noted that the outraged looked mighty pleased at the party. (The rise and fall of Jay Gatsby may come to mind.) The New York Times wrote an editorial about “Plutocrats and Moralizers”. John Kenneth Galbraith followed by quoting Thorstein Veblen. Such consumption is within “the higher stages of the barbarian culture”. Soon after, a best-selling book would immortalise the KKR and RJR Nabisco deal: Barbarians at the Gates.

Regards,
Fred Sheehan

for Whiskey and Gunpowder

Fred Sheehan is columnist and economist with Marc Faber's Gloom, Doom and Boom Report.

Global Exodus from the US Dollar in Motion - Gary Dorsch

by Gary Dorsch

Trading in the arcane world of foreign exchange is often akin to judging a reverse beauty contest. The trick to profitable trading is to pick the least ugly currency. Nearly all fiat or paper currencies are ugly, because the 18 of the world's top-20 central banks are inflating the money supply at double digit rates. At the moment, the world's two ugliest currencies are the Japanese yen and the US dollar.

The Bank of Japan pegs its overnight loan rate at just 0.50%, in a brazen effort to devalue the yen, to boost exports abroad, and prevent an abrupt unwinding of the mushrooming "yen carry" trade. Meanwhile the Federal Reserve is inflating its M3 money supply at a 13.7% annualized clip, according to private economists, which if correct, would be the fastest rate of expansion in more than 30-years.

US Treasury chief Henry Paulson, and former chairman of Goldman Sachs, GS.N, "monitors the financial markets closely," and has reinvigorated the infamous "Plunge Protection Team," which comes to the rescue of the US stock market whenever nasty revelations come to the surface. At the moment, Paulson's grand strategy is to offset losses in the US housing sector with big gains in the stock market, to prevent the US economy from sliding into recession.

A key player in the "Plunge Protection Team" (PPT) is none other than Federal Reserve chief Ben "helicopter" Bernanke. Since the Bernanke Fed discontinued the decades-old reporting of the broad M3 money supply in March of 2006, the growth rate of M3 has accelerated from an 8% rate to a sizzling 13.7% clip, its fastest in more than three decades. The Bernanke Fed is preventing borrowing rates from rising at a time of explosive loan demand for US corporate mergers and takeovers, by rapidly increasing the US money supply.

The Bank of America, Citigroup, and JP Morgan led US loan underwriting in the first half of 2007, which totaled $943 billion, up 5.4% from a year earlier. Global mergers and takeovers soared to an astronomical $2.78 trillion during the first six months of the year, up 51% from a year ago, led by $1.05 trillion in the US alone. Buy-outs by private takeover artists soared 23% to a record high of $568 billion in H'1 2007, with 35% of US takeovers, and 13% of European takeovers financed with debt.

But one sector of the US stock market which has not responded positively to the Fed's heavy injections of monetary steroids has been the home builders, once regarded as a top bull-market leader from 2003 thru August 2005. The Dow Jones Home Construction Index, a yardstick that measures home builder performance, is off 25% this year, and is flirting with key support at the 525 level, which if penetrated, would be especially bearish.

On July 2nd, Paulson sent a discreet signal to Wall Street power-brokers to avoid dumping the home builders. "In terms of housing, it's had a significant impact on the economy. No one is forecasting when, with any degree of clarity, that the upturn in housing is going to come, other than it's at or near the bottom."

The Fed has obscured its money printing operations by discontinuing the reporting of M3, in order to limit the damage to the fixed income markets. But word of the explosive growth of the M3 money supply is slowly leaking out, and taking its toll on the US Treasury Note market, which briefly tumbled to its lowest level in five years in June, lifting 10-year yields as high as 5.30%, before receding back to 5.00%, on a "flight to safety" from the riskiest of the sub-prime home loan market.

Because the US credit markets are swimming in a tidal wave of rising liquidity, there will always be bargain hunters who are happy to park excess cash into the bond market whenever yields surge higher. Asian central banks and Arab Oil kingdoms in particular, have been big buyers of US T-bonds over the past four years, and hold roughly $1.3 trillion of the IOU's, but even this massive intervention couldn't turn the tide of the four-year bear market.

But now there are indications that China's insatiable appetite for US T-bonds is waning. Beijing was a net seller of $5.8 billion of US T-bonds in April, the first drop in Chinese holdings since October 2005, and sparking the recent slide that lifted 10-year yields by 70 basis points, at its high mark. Since Beijing unhinged the dollar from a fixed peg of 8.27 yuan in July 2005, the value of the US 10-year T-note, when converted into yuan, has declined by 15 percent. Earlier today, the dollar slipped to 7.59 yuan, or 8.9% lower since the yuan was freed from the dollar peg.

If Beijing understood the full extent of the Fed's money printing operations, it might think twice about putting its hard earned dollars into Treasury IOU's. Beijing is almost guaranteed to take further losses on its massive $900 billion US bond portfolio, with its secret agreement with Paulson, limiting the dollar's annual devaluation against the Chinese yuan to 5%, to avoid the US Treasury's label of a currency manipulator.

China to diversify future FX Reserves away from US dollar

But China's old guard is finally waking up to reality, and looking for new ways to invest its bulging foreign currency reserves. China's FX reserves have more than tripled in three years after rising $209 billion in 2005, $207 billion in 2004 and $117 billion in 2003, and in the first quarter of 2007 alone, its treasure chest was bloated by a whopping $136 billion to a record $1.2 trillion.

Last Friday, the National People's Congress authorized the Ministry of Finance to set-up the State Investment Company, (SIC), which will invest $200 billion of the country's FX stash, into publicly listed companies, real estate, or private deals around the globe. Mostly likely, at the bottom of the list of possible Chinese investments are US Treasury bonds, which are a losing proposition due to heavy pressure for a further slide of the US dollar against the yuan.

The Ministry of Finance plans to issue 1.55 trillion yuan ($203.49 billion) of bonds to the People's Bank of China (PBoC), in a swap for the FX reserves that will be managed by a new investment fund. But the PBoC is also authorized to re-sell the giant bond offering, which would mop-up liquidity in the Shanghai money markets. If the PBoC parcels out the entire block of bonds, it would have the same effect as lifting the bank reserve requirements by 10 times with a magnitude of 0.5% each.

The sale of 1.55 trillion yuan of these special bonds would be equivalent to more than 50% of the government's 2.9 trillion yuan outstanding debt. China's parliament also authorized the State Council to abolish or reduce the 20% withholding tax levied on interest income. The measure is aimed at staunching the flow of cash into the surging stock market by making bank deposits more attractive.

Cancelling the tax entirely would be the equivalent to an increase in the after-tax one-year deposit rate of about 60 basis points, while a 50% reduction would boost after-tax interest by about 30 basis points. It would also increase the after-tax interest rate on China's 7-year bond by as much as 80 basis points. Already, China's 7-year bond yield has climbed 120 basis points to 4.22% since April 2nd, and now the central bank has new tools to drain liquidity from the money markets.

Higher Chinese interest rates have put a roadblock before the powerful Shanghai red-chip index, which has found stiff resistance at the 4,300 level, but finding support at 3,700. "China should appropriately tighten monetary policy to prevent relatively fast economic growth from overheating, and maintain stability," the People's Bank of China said on July 3rd. The PBoC said it "would resort to a range of monetary policy tools to achieve reasonable growth in money and credit."

With higher after-tax interest rates on Chinese bonds, and pressure on the Fed to lower the fed funds rate due to the sub-prime home loan meltdown, hot money from abroad should continue to flow into the Chinese yuan, greasing the skids for the US dollar's slide against other Asian currencies, such as the Korean won.

Bank of England - Pioneer of "Asset Targeting"

Just about every major central bank has a big credibility problem, when it comes to maintaining the purchasing power of its currency. The Bank of England, for instance, has tolerated double-digit growth of its M4 money supply for the past two years. The BoE is the "Group of Seven's" original pioneer in "asset targeting," or guiding the stock and real estate markets to higher levels, by injecting excess liquidity into the markets, until asset prices reach the bank's targeted levels.

The BoE has guided the Footsie-100 from a low of 3,500 in Q'1 of 2003, to a 7-year high above 6,600 this month. But the BoE's monetary abuse that has taken place over the past few years, is taking its toll on the British debt markets, where the benchmark 10-year gilt fell to a 7-year low in June, lifting its yield to as high as 5.55%, before bargain hunters came out of the woodwork..

"Investors are likely to take advantage of this ample liquidity and the associated easy credit to purchase other assets, driving risk premia down and asset prices up," the BoE said in a February 20th, report for parliament's Treasury Committee. "In due course, those higher asset prices may be expected to feed through into higher demand for goods and prices, putting upward pressure on the general price level."

In a speech to mark the tenth anniversary of the central bank's independence, BoE chief Mervyn King said on May 2nd, "It is unfortunate, if monetary developments are given insufficient attention in the analysis of the inflation outlook. The growth of money and credit may signal in advance of other indicators that the Bank rate is set at a level inconsistent with bringing inflation back to the target in the medium term."

The BoE is well aware of the inflationary consequences of double-digit money supply growth, and London futures markets are pricing in two BoE rate hikes to 6% in the days and months ahead. But the BoE must still overcome stiff political opposition to higher borrowing costs, namely from newly installed prime-minister Gordon Brown. "Rigid monetary rules that assume a fixed relationship between money and inflation do not produce reliable targets or policy," Brown argued on June 14th.

Such reckless comments by Mr Brown, are reminiscent of his decision to sell off more than half of the UK's centuries-old gold reserves in May 1999. The decision to sell 400 tons of gold is seen in City circles as a financial bungle on the scale of the Tories' "Black Wednesday" that cost the taxpayer 3.3 billion pounds. Brown offloaded the gold at a 20-year low in 17-auctions between $256 and $296 /oz, with an average of $275 /oz. Since then gold has risen sharply and stands around $650 /oz.

Judging from the chart above, the BoE is still far behind the monetary inflation curve, and would have to hike its base rate by 100 basis points to 6.50% or higher, to rein-in M4 growth into single digits. Ultimately though, the pressure on the BoE to hike interest rates further will come from the gilt market, which is in danger of a nasty meltdown, unless the central bank lives up to expectations of future rate hikes.

Mitigating some of the pressure for sharply higher BoE rates however, is the strength of the British pound, which climbed above the psychological $2 mark last week, for only the second time since 1980. The British pound is being driven higher by widening interest rate differentials moving in its favor, with the Federal Reserve handcuffed by a weakening housing market and a sub-prime loan debacle.

Both the British pound and US dollar are heavily inflated currencies. Both offer large external trade deficits and big budget deficits. While the Fed is inflating its M3 money supply at a 13.7% clip, the Bank of England is inflating its M4 at a 13.9% annualized clip. But the US economy is roughly six times the size of England's, so in absolute terms, the increase in supply of US dollars is much larger. And with the BoE expected to lift its lending rates to 75 basis points above the US$ rate, the pound is winning this "reverse beauty" contest.

Aussie Dollar Shines with Yield hungry Investors

After breaking thru the long held psychological barrier of 80 US-cents in March, one has to go back 18-years to find the last time the Aussie dollar traded as high as 86 US-cents. There are several reasons why the Aussie dollar is climbing sharply higher against the greenback, but the most commonly cited is higher yields. Yesterday, the yield on Australia's 10-year Treasury bond was +122 basis points (bp) higher than comparable yields on the US T-Note, up from +56 bp in April 2006.

Interest rate differentials play a big role in the FX "reverse beauty" contest, and the Aussie has been underpinned by its relatively attractive yield. Yet why are Aussie bond yields rising relative to US yields? Flush with cash after a string of budget surpluses, the Australian government issues barely enough new paper to cover rolling maturities, keeping bonds outstanding at just A$60 billion, and down from around A$94 billion when Prime Minister John Howard came to power in 1996.

That is in sharp contrast to the United States where total public debt has ballooned by 50% since the turn of the century to reach $8.8 trillion. Issuance of marketable Treasury paper has likewise surged to $5 trillion, with $1.2 trillion of that held by offshore central banks.Aussie T-bonds offer the same triple-A rating, and with an appreciating currency, one might have expected Aussie yields to shrink relative to US T-Note yields. This Aussie yield spread is one of the market's great mysteries.

The Reserve Bank of Australia (RBA) isn't thrilled about the sharply higher Aussie dollar, which is bound to hurt exporters and widen the current account deficit, which jumped 20% to A$15.1 billion in Q'4, the largest quarterly shortfall on record, with the 12-month rolling total equal to 5.9% of the country's GDP. The RBA intervenes every month to sell Aussie dollars and slow its upside gains.

In the game of competitive currency devaluation with other central banks, the RBA has allowed its M3 money supply to expand at a 14.1% annualized rate, pumping up the local stock market but undermining confidence in the Treasury bond market. Aussie 10-year bond yields rose above the psychological 6% level in June, for the first time in five years.

In order to rein in the explosive growth of Aussie M3, the RBA would probably be required to hike its cash rate by 100 basis points to 7.25%, but that could send the Aussie dollar soaring into orbit against the Japanese yen, its top trading partner. Thus, the RBA's anti-inflation fighting capability is held hostage by the Bank of Japan, which won't lift its interest rates into alignment with the rest of the world.

Indirectly, the BoJ is exporting inflationary pressures into the Australian economy, with its super-low interest rate, and cheap yen policy. In turn, Aussie 10-year bond yields are rising faster than Japanese bond (JGB) yields, lifting the spread to +430 bp over JGB's, and catapulting the Aussie dollar to a 16-year high of 105-yen.

Japanese fixed income investors have become an integral part of the infamous "yen carry" trade, purchasing a large block of Australia's outstanding A$521 billion of foreign debt, seeking to profit from the yen's devaluation. But should the BoJ start to lift its interest rates to narrow the gap with the rest of the world, the carry trade could unwind, perhaps in a violent fashion.

The Bank for International Settlements pointed out on June 24th, that "there is clearly something anomalous in the ongoing decline in the external value of the yen. Tighter monetary policies would help to redress this situation, but the underlying problem seems to be a too firm conviction on the part of investors that the yen will not be allowed to strengthen in any significant way," the BIS said.

"If global trade imbalances need to be resolved, a further and perhaps substantial decline in the dollar might be part of the adjustment process," it warned, adding the yen could rise sharply once market sentiment shifts. But traders have heard these empty warnings for years, and the yen has stayed weak, in large part due to a gentleman's agreement between the US Treasury and Japan's ministry of finance.

BIS chief calls for Responsible Monetary Policies

Central bankers are playing a game of "Smoke and Mirrors" inching up interest rates at a snail's pace, but not high enough to curb explosive loan demand nor the growth of the money supply. But BIS General Manager Malcolm Knight is now calling on the world's top central bankers to slow down the printing presses, and allow borrowing rates to rise, to start draining the "Global Liquidity Glut," in earnest.

"Financial conditions are still accommodative, access to credit remains easy and credit spreads are at record lows. Containing inflationary pressures seems to require further tightening in most jurisdictions, as is expected by financial markets," he said.

"The credibility of central banks around the world may hinge on their response to surging money and credit growth, which is helping fuel asset bubbles. Some central banks need to ask soul-searching questions about the appropriate policy response. Ultimately, the credibility of central banks lies in the balance," Knight added.

Central banks in Australia, Canada, China, England, the Euro zone, Korea, South Africa, and Switzerland are expected to heed the call of the BIS chief, by lifting short-term rates a half-percent higher, albeit at a baby-step pace in the second half of 2007. Even the radical inflationist Bank of Japan is laying the groundwork for a long overdue quarter-point rate hike to 0.75% this summer.

"To stand pat on monetary policy for a long period of time is not a prudent strategy, since the acceleration of economic activity may in the future come to require a large adjustment in the policy rate, causing unnecessary swings in economic activity and prices," said BoJ member Kiyohiko Nishimura on July 3rd. But he added the BOJ must adjust rates slowly, "in line with economic and price developments."

The growing presence of Japanese retail investors in foreign bond markets has led to increased volatility in the foreign exchange market. "A sudden change in their behavior is likely to shift the direction and the magnitude of trading in foreign exchange markets, and heightens the risk of a sharp pull-back of "yen carry" trades that could destabilize financial markets," Nishimura warned.

FX market Expects an Easier Fed Policy in H'2 2007

One central bank that cannot contemplate higher interest rates however, is the Bernanke Fed, which is hamstrung by a sliding market for the weakest sector of the sub-prime mortgage loan market. The benchmark ABX 07-1 BBB index, which is tied to sub-prime mortgage loans, fell to 53.16 cents on the dollar, and has tumbled 43% since January. ABX's are sub-prime loan mortgages which are bundled in securities.

The fallout from the slide in sub-prime ABX's is uncertain, but if left unchecked, tighter lending standards could sink the US home building sector and housing prices, which were 2.7% lower, in May from a year earlier. Foreign currency traders are already upping their bets that the Bernanke Fed will continue its clandestine policy of injecting more US dollars into the banking system, and eventually lower the fed funds rate in a crisis situation. Coupled with the likelihood higher rates overseas, yet another global exodus from the US dollar has been set in motion.

In retrospect, it was Bernanke's infamous comments in a letter to California Rep Brad Sherman, dated Feb 15th, 2006 which began the dollar's latest 18-month descent. "A precipitous decline in the dollar, should not necessarily disrupt financial markets, production or employment," Bernanke wrote, portending the central bank's rapid increase in the growth rate of the US money supply.

Two months later, Russian finance chief Alexei Kudrin put the knife into the US dollar, by telling the IMF that Moscow could not consider the dollar as a reliable reserve currency because of its instability. "This currency has devalued by 40% against the Euro in recent years. The US dollar is not the world's absolute reserve currency. The unsustainable US trade deficit is causing concern and that the international community can hardly be satisfied with this instability," Kudrin told a stunned audience of the world's top central bankers in April 2006.

On November 24th, 2006, Chinese deputy central bank governor Wu Xiaoling warned "The exchange rate of the US dollar, which is the major reserve currency, is going lower, increasing the depreciation risk for east Asian reserve assets."

Russian Bear aligned with "Axis of Oil" meets President Bush

Russian kingpin Vladimir Putin has been a notorious bear on the US dollar for the past few years, and is a key member of the "Axis of Oil" including American foes Iran's Mahmoud Ahmadinejad and Venezuela's Hugo Chavez. All three members of the "Axis of Oil" have been switching their FX reserves away from the US dollar and switching into Euros.

At a two-day meeting in Kennebunkport, Maine, Bush called Putin, "solid partner," and added that "Russia has made amazing progress in such a short period of time," since Soviet Union collapsed in 1991. "Russia is a country with no debt, and it's a significant international player. Is it perfect in the eyes of America? Not necessarily. Is the change real? Absolutely," Bush said. Putin responded by saying, "The deck's been dealt and we are here to play. I would very much hope that we are playing one and the same game."

At the core of their disputes however, is Putin's alignment with Iran's Ayatollah Khamenei, his support for Iran's nuclear program, and Moscow's opposition to further UN sanctions on Tehran, which could wreak havoc on Iran's economy. Putin also opposes Bush's plan to create a European-based missile-defense system with radar based in the Czech Republic and interceptors based in Poland.

Russia is the world's largest natural gas producer, and is second to Saudi Arabia as the world's top crude oil exporter. Rising oil prices have helped Russia amass foreign currency reserves of $405 billion, the third largest after China and Japan. Russia's economy expanded at a 7.7% annualized rate in the first five months of this year, while the US economy grew at only 0.7% in Q'1, or a tenth of Russia's performance.

On April 6th, 2007, Russian central bank chief Sergei Ignatyev said the approximate structure of Russia's foreign exchange reserves was 50% in US dollars, 40% Euros, and 10% in British pounds. Last year, Putin ordered payments for Russia's Ural oil exports in rubles, abandoning the US dollar as a medium of payment. Iran's Ahmadinejad has ordered payment for Iranian oil exports in Euros.

Higher oil prices would increase the wealth the "Axis of Oil" and the clout of the Arab Oil kingdoms in the Persian Gulf, which control an estimated $1.6 trillion of FX reserves, outstripping the Chinese dragon. One has to wonder what impact a possible military confrontation over Iran's nuclear weapons program would have on the foreign exchange market.

For additional commentaries and market analysis, consider a subscription to the Global Money Trends newsletter, published on Friday, for 44 issues per year!

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Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

Disclaimer: SirChartsAlot.com's analysis and insights are based upon data gathered by it from various sources believed to be reliable, complete and accurate. However, no guarantee is made by SirChartsAlot.com as to the reliability, completeness and accuracy of the data so analyzed. SirChartsAlot.com is in the business of gathering information, analyzing it and disseminating the analysis for informational and educational purposes only. SirChartsAlot.com attempts to analyze trends, not make recommendations. All statements and expressions are the opinion of SirChartsAlot.com and are not meant to be investment advice or solicitation or recommendation to establish market positions. Our opinions are subject to change without notice. SirChartsAlot.com strongly advises readers to conduct thorough research relevant to decisions and verify facts from various independent sources.

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Investing in Iraqi Oil - Dan Amoss

by Dan Amoss

Corruption Smothers Oil Industry in Iraq

Free markets are the lifeblood of a civilized society. But they are fragile. If they are to survive, contracts must be honored and property rights must be protected.

Beyond these basics, free markets work optimally when everyone follows the “Golden Rule” and treats everyone else as they’d like to be treated. Corruption -- including the use of political influence or violence to achieve results -- smothers free markets and the civilized societies they nourish. Once corruption gets out of control, everyone forgets about serving their fellow man and focuses their full attention on how they can game the system.

Sadly, corruption is a serious problem in Iraq -- a problem that started out as a way to “get things done” within the bureaucracy of Saddam Hussein’s gradually decaying dictatorship. Now it threatens the future economy and stability of the entire Middle East.

Pipeline Thefts and Violence Plague Northern Iraq

The giant Kirkuk oil field in the Kurdish region of northern Iraq has been fought over since it began producing oil over 70 years ago. The Baath government realized that control of Kirkuk was necessary to solidify its grip on the Iraqi oil industry, so in 1975, it initiated an “Arabization” program. Over the next few decades, Arabs from southern Iraq were incentivized by the government to displace ethnic Kurds in Kirkuk. Ever since the 2003 ouster of Saddam, the tables have turned, and the Kurds have fought for as much autonomy as they can get.

Yet despite the autonomy they’ve gained, the Kurdish leadership -- even with the help of the Iraqi government and the U.S. Army -- can’t ensure that Kirkuk’s crude oil gets shipped to market into reliable fashion.

The Wall Street Journal recently published a front-page story about uncontrollable pipeline siphoning in Iraq. The pipeline system delivering oil out of the Kirkuk region is too widespread to protect, so it’s an ideal target for a wide range of unsavory characters: “unruly desert tribes, bomb-planting insurgents, corrupt security forces, cross-border smugglers, and operators of small domestic refineries. At those refineries, U.S. officers believe, raw oil is turned into fuel and sold on the black market, where it’s used in vehicles and to power home generators. This loose confederation has all but crippled production in Iraq’s northern oil fields, even as the political future of this ethnically mixed city and its underground riches hangs in the balance.”

In the midst of this free-for-all, how can an Iraqi government that relies heavily on oil export revenues remain financially viable? The WSJ article continues:

“In the second half of [2006], one stretch of pipelines connecting Kirkuk with the Turkish Mediterranean port of Ceyhan -- the main outlet for Iraq’s northern oil exports -- pumped oil for only 43 days. The rest of the time, the pipes sat idle, leaking crude through dozens of holes drilled along their 200-mile run through the Iraqi desert. One pipeline has been broken into 39 times so far this year, according to U.S. military officials.

“The holes help explain why, four years after the U.S. invasion, Iraq hasn’t been able to match its prewar crude production levels of 2.5 million barrels a day. This year, Iraq is averaging 1.9 million barrels, mostly from southern oil fields that haven’t suffered the unrelenting sabotage seen in the north. Kirkuk currently produces 180,000 barrels of oil a day, but under normal conditions, it could produce an additional 400,000 barrels a day.”

Sectarian and tribal loyalties complicate the situation even further:

“The Northern Oil Co. has found itself at the center of the ethnic tensions. Of its 12,000 employees, only a few hundred are Kurds…

“Mr. Abdullah, the Northern Oil director, has been hiring Kurds, though he admits only 500 or so have come to work. Being an oil worker here has become increasingly dangerous. Pipeline repair crews have been hit by roadside bombs and shot at. Sunni insurgents have been dropping leaflets in Kirkuk telling all government employees, including oil company workers, to quit or face a bloodbath.

“Last summer, Adil al-Qazaz, Northern Oil's director-general at the time, went to Baghdad to visit the Oil Ministry. After his meeting, he was snatched by gunmen on the street, never to be seen again…

“Among the Iraqi security forces, the strategic infrastructure battalions have one of the strangest histories. In the aftermath of the U.S. invasion, Northern Oil tapped the Sunni Arab tribes to protect the pipelines running through their turf. Mr. Hussein used a similar system, mixing intimidation and rewards to secure cooperation of the tribal sheiks. After 2003, the oil company started direct payments to the sheiks, who would in turn distribute the money to the tribal guards. Essentially, the tribes were being paid to refrain from attacks on the pipeline.”

Despite the fact that southern Iraq hasn’t suffered the “unrelenting sabotage” occurring in the north, there’s little reason to expect a much better long-term outcome.

Smuggling and Iranian Control Plague Southern Iraq

Ghaith Abdul-Ahad, a journalist with the U.K. newspaper The Guardian, crafts very insightful articles from interviews that are clearly difficult and dangerous to get. In “Oiling the Wheels of War,” he takes us into the underworld of oil smuggling in Iraq:

“On the banks of the Shatt al-Arab in southern Iraq, a family business is thriving. For the Ashur, a small clan of about 50 families, it’s worth several million dollars a week. Costs are steep, especially for security. But profits are tidy and business is booming.

“The Ashur smuggle oil. For years under Saddam Hussein, they worked as mere guards at Abu Flus terminal at the mouth of the Gulf. But as the state collapsed after the U.S. and British invasion in 2003 and economic anarchy set in, they took over the port and became the quasi-official authority there. Never have the family’s fortunes flourished as in the last three years. They built their own underground oil tanks in their farms, where fuel tankers empty their cargoes to be pumped later into small pontoons. A cousin of the family estimates that they make about $5 million (£2.5 million) a week from smuggling oil.

“When another tribe tried to take over the ports, the family hired gunmen from outside Basra to defend its fiefdom. ‘We were paying $250,000 every week for gunmen just to make sure that we keep our terminals and preserve our rights,’ said the cousin, Abu Harith.

“The family operation is a dispiriting example of how large swaths of Iraq’s economy and mineral wealth have vanished into a legal vacuum, where the state is absent, law enforcement is nonexistent, and the spoils are shared by politicians, militias, and smuggler gangs.”

Groups like the Ashur clan seem as powerful as any organized crime ring in history. Militias fight over neighborhoods in oil-rich southern Iraq as fiercely as mafia elements defend their “turf.” Only their effect on society is even worse, because they control politicians and police officials. So the authorities wouldn’t want to do anything about this smuggling problem, even if they could. Abdul-Ahad provides a bit more color on a society that’s corrupt to the core:

“Oil is not the only industry steeped in corruption. Businessmen in Basra say anything connected to the state requires payments to militias and parties. In construction, for example, Abu Harith said: ‘There are two deals with parties and militia; one, they give you the contract for a price, but then you have to provide your own security; the other deal is that for a certain percentage of the contract, they will provide you with gunmen. No other militia will attack you.” In his last four contracts, he has paid $500,000 in bribes.

“But oil is the biggest racket of all in a country with the world’s second largest reserves. Oil worth millions is being smuggled out of southern Iraq every day and sold on the black market. The proceeds fund militias, mobsters, and corrupt politicians with cash that far outstrips the state’s financial resources.

“The smuggling also fuels factional fighting around Basra as each group tries to control its portion of the supply.

“One tanker captain, who is in his second decade of oil smuggling and owns his own ship, told The Guardian how lucrative the trade could be. ‘The big profits are to be made in crude oil,’ he said. ‘You rent an oil tanker, and after your first trip, you can buy the tanker.’

“The infrastructure of smuggling was set up under Saddam in the late 1990s, during the U.N. sanctions, when illegal oil shipments became the main method of getting cash into the country. Smuggling was an officially condoned policy…

“The captain, who specializes in crude smuggling, explained the process: ‘It depends on the officials manning the terminal when your tanker arrives. Usually it’s a committee of three-four; they are all of one [political] party. Your contact with that party arranges everything in advance.’

“Once the tanker is filled, another official usually arrives -- a surveyor hired by the government to inspect the cargo -- who is bribed to pass everything off as legitimate. The route of the tanker then differs, depending on its papers.

“The main risk is being stopped by patrolling U.S. or British vessels. ‘If I have official papers then all is fine, even if I am carrying twice the stated shipment,’ said the captain. ‘When I don’t have papers, we cross into Iranian waters, we carry an Iranian flag and bribe the Iranian coast guard. It’s a great business for them too. If we are arrested by the Iraqi navy, it’s easy. They are involved in the party, after all.’”

So every politician in southern Iraq has his hand in the till. We shouldn’t be surprised that the Iraqi parliament is making little progress in initiatives to secure the country. Most Iraqis are positioning for what they expect will be a violent land grab once the U.S. eventually withdraws its forces.

The violence in Baghdad may be getting all the press, but a far more significant development for global oil markets is Iran’s strengthening influence in Shia-dominated southern Iraq. In “Welcome to Tehran,” Abdul-Ahad’s interviews in Basra paint a picture of a critical port city now controlled by militias -- including several Iranian proxies. According to a senior Iraqi military intelligence official, “In Basra, Iran has more influence than the government in Baghdad…If a war happens, [the Iranians] can take over Basra without even sending their soldiers.”

Union Heritage of Iraq’s Oil Workers

Considering all the turmoil in the most oil-rich area of the world, it’s hard to argue that there shouldn’t be a geopolitical premium in the price of crude oil. The price of oil should embed an “insurance” component that fluctuates with the odds of a major supply disruption. To argue otherwise is to ignore the conditions under which most of the world’s oil is produced.

But the challenges facing future Iraqi oil production don’t end with corruption and sectarian violence. International oil companies with state-of-the-art technology have meager chances of gaining -- and holding -- concessions to produce Iraqi oil. Not only would they have to operate in the midst of warring militias, but they’d also have to go through the 26,000-member Iraqi Federation of Oil Unions.

In "Iraq Oil Union Has Storied Past", Ben Lando from United Press Intl. highlights the strong feelings Iraq’s oil workers have about the oil law under development:

“Hassan Jumaa Awad wants Iraq’s oil to stay under state control, and the unionists, who have long worked the rigs, to be supported in developing the national resource. But this is no request from the president of the Iraqi Federation of Oil Unions.

“It’s a demand.

“‘Since we are working to make progress in production, we need a real participation in all the laws that are related to the oil policy,’ Awad told United Press Intl., speaking on his mobile phone from the southern port city of Basra. ‘We are the sons of this sector and we have the management and technical capability and we have the knowledge on all the oil fields.’

“The IFOU represents more than 26,000 workers organized under various unions in the oil-rich southern and northern areas of Iraq. Shiites, Sunnis, and Kurds, together they’ve operated Iraq’s oil sector before, during, and after Saddam Hussein. Their rights to officially unionize are still denied under a 1978 Saddam law, one of a few of the former president’s laws the U.S. occupation and the Iraqi Parliament upheld…

“Kurdish and central government negotiators reached a deal last month on the framework for a law governing Iraq’s oil. Details on ownership rights and revenue sharing are still far from finalized. The Iraq National Oil Co. would restart, but compete with foreign oil companies, who could win contracts giving them partial ownership of the respective fields.

“INOC ‘should have full privileges,’ Awad said, ‘and we don’t agree on the production partnership.’

“Iraq’s oil has been nationalized for four decades. Iraqis view it with a pride of ownership, something the law would reduce if the contract language allowing for foreign ownership stands.

“‘We think that to reserve sovereignty of Iraq is to be able to control the oil wealth,’ Awad said, and foreign investment should be limited to technical assistance. ‘I wish if the foreign companies were to come into Iraq, that they help us,’ Awad said. ‘Not to suck the blood of the Iraqi people.’

“The unions were kept in the dark, as were most members of Iraq’s parliament, until the draft law was leaked to the media. Even then, it was still out the reach of most of Iraq’s citizens…

“The IFOU could shut down Iraq’s production if the draft hydrocarbons law stands. With oil revenue funding 93% of the federal budget, that’s a large bargaining chip…”

Iraq’s oil industry will probably resemble Saudi Arabia’s in the future, with no foreign ownership of resources in the ground -- not good for those hoping for endless cheap supplies of oil from the Middle East.

And what exactly lies under the ground in Iraq?

Nobody knows for sure. But institutions like the Energy Information Administration and BP act as if they do. They publish OPEC reserve figures as if they were concrete facts.

So I’ll leave you with a set of figures from BP’s recently published Statistical Review of World Energy. I drew BP’s estimates of oil production in Iraq and Iran since 1965 into this chart:

I included dotted lines to draw your attention to the eight years in which the horribly destructive Iran-Iraq war occupied the full attention of the entire fighting-age generation. The war also consumed the economies of both countries. Production dropped dramatically and recovered very slowly.

Yet it’s an amazing coincidence that during this same time period, while fighting a war involving millions of soldiers, both Saddam Hussein and the Iranian mullahs had the resources and ability to conduct what appear to be massive oil exploration programs. At least that’s what you’d think looking at the chart of stated crude oil reserves below:

The real story behind these reserve numbers is that they are simply fudged out of necessity and likely overstate recoverable resources by a significant amount.

Sure, oil field technology developed in the 1980s allowed for the production of oil that would previously have been out of reach. But these reserve increases have more to do with OPEC production quotas than reality. In the 1980s, OPEC decided to tie production quotas to reserves. This created a huge incentive to overinflate reserves, especially for the cash-strapped Iraqis and Iranians desperate for oil revenues to fund their war.

We have every reason to question these figures. And we have every reason to expect that no matter how much oil lies under the ground in Iraq, it will be produced in an erratic, unreliable fashion.

Good investing,
Dan Amoss, CFA

For Whiskey and Gunpowder

Dan Amoss is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland - investment advisors tor one of America's top small-cap value mutual funds over the past 15 years.